The last few week’s we have seen quite a bit of volatility in the market due to several mixed events in the economy for example, the market trading at all time highs, the much discussed “sequestration” budget cuts and the Italian elections, which have produced quite a bit of volatility and have pushed the market up and down.

Today we are going to discuss the VIX index. If you do an internet search on VIX you will find some interesting results: a swim wear catalog, the name of a rock band and the Vienna Internet Exchange. Interesting stuff, but not quite what I want to discuss. The CBOE’s VIX is a popular market-timing indicator. Let’s take a look at how the VIX is constructed and how investors can use it to evaluate U.S. equity markets.

VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index, and is a popular measure of the implied volatility of the S&P 500 index. The VIX is often referred to as the fear index The VIX also represents one measure of the market’s expectation of stock market volatility.

How did the VIX come to be? The first VIX, introduced by the CBOE in 1993, was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors’ expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

During periods of market turmoil or uncertainty, the VIX often spikes higher, because there is a panic demand for OEX Puts as a hedge against further declines in the overall stock market. During more bullish periods, there is less fear and, therefore, less need for stock investors and portfolio managers to purchase puts. This is why, As stated above the VIX is often referred to the “fear index” or sometimes the “fear gauge” because at times when the index rises because of market volatility increases, the market tends to be in more of a panic and often the panic leads to a market sell-off. Conversely, during times when the market is calmer either ranging, or a

steady trend the VIX is lower as the volatility is lower. This inverse relationship in the market is illustrated by the graphs below.

Notice that as the VIX spikes up in June 2012 and Late Dec 2012 the S&P index moved lower, but as soon as the VIX index calms down the Market goes up. One saying about the VIX that investors will hear in relation to the VIX is this: “When the VIX is high, be ready to buy. When the VIX is low, look out below!” this is illustrated in the charts above, generally speaking when the markets are In a panic, the VIX is high. After this selloff or panic is over, and VIX retraces the market is generally in a good place to rebound or move higher.. So understanding market sentiment using the VIX index is a valuable tool for investors looking for some clarity about the market direction.

Traders Challenge:

This next month, Look at the VIX index and follow the market volatility Also, become familiar with the inverse relationship between the VIX and the S&P indexes.